The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (TheStreet) -- An interesting aspect of Joel Greenblatt's Magic Formula Investing (MFI) strategy is that its precepts can be applied to a variety of other stock strategies and focuses. For example, if you like to invest in small caps, MFI can be used to find good, undervalued businesses in a sector that is under-followed by professional equity analysts. If you are looking to invest in foreign markets, MFI can be applied to stocks in foreign exchanges, and so forth.
We can also go the other way, and apply additional criteria to stocks in the official MFI universe. In theory, doing this starts us with a list of good, undervalued companies, weeding out a lot of junk from the beginning. This article will focus on combing through the three screens covered by MagicDiligence (top 50 over $50 million and $1 billion, top 30 over $3 billion), looking for MFI stocks with relatively safe dividend yields above 3.5%, providing ongoing income for investors:
1. Altria Group (MO)Forward Dividend Yield: 5.7% Free Cash Flow Payout Ratio: 115% Consecutive Years of Dividend Hikes: 43 Magic Formula Earnings Yield: 9.1% Magic Formula Return on Capital: 44.3% Altria Group is the largest tobacco company in the U.S., producing the No. 1 brand of cigarette (Marlboro), and the No. 1 brand of smokeless tobacco (Copenhagen). Competitive dynamics are strong, as oppressive government regulation in the U.S. shuts out new competitors and hurts discount labels more than premium brands, and the firm produces copious amounts of free cash flow. Altria is a "dividend aristocrat," raising the dividend for 43 consecutive years. Recently, though, dividend payments have begun to outstrip free cash flow, so this is something to watch. Competitors Reynolds American (RAI) and Lorillard (LO) are also Magic Formula stocks and also interesting dividend investments. 2. Eli Lilly (LLY) Forward Dividend Yield: 5.3% Free Cash Flow Payout Ratio: 36% Consecutive Years of Dividend Hikes: 42 before being broken in 2010 Magic Formula Earnings Yield: 16.0% Magic Formula Return on Capital: 54.1% One of the largest pharmaceutical makers in the world, with products like Cymbalta for depression and antipsychotic Zyprexa. The payout ratio is modest and Lilly has a stellar dividend record. Some concerns are a high debt load after purchasing ImClone in 2008 and a large patent cliff in the next 2 years (over 40% of sales). A decent pipeline of new drugs and cost cutting will be key in maintaining and raising the dividend, and the payout ratio is safe for now. At a 16% earnings yield, there is also significant capital appreciation potential if the R&D pipeline can deliver. Like tobacco, branded pharmaceuticals have an outstanding long-term investment record.
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